published Wednesday, April 30th, 2014

Personal Finance: Investors still getting in their own way

Chris Hopkins

Suppose you had dropped $10,000 into a low-cost S&P 500 index fund 20 years ago and then never opened another account statement. Despite a devastating terror attack on New York City, two major market crashes, a banking system meltdown, and a global recession, your investment would now be worth over $55,000.

Now consider the average equity mutual fund investor. The same hypothetical $10,000 invested 20 years ago is now worth $26,000. What gives?

It turns out that over the long run, it is neither economic cycles nor stock market bubbles that kill our returns. To quote the renowned market sage Pogo: "We have met the enemy, and he is us." Investors routinely impede their own investment returns by responding to instinctive psychological signals that cause them to move in and out of the market at the wrong time. We know that consistently timing the market is impossible, but we keep doing it anyway.

Over the past 30 years, according to data firm Dalbar, stock fund investors have lagged the market by a whopping 7.4 percent per year. Fortunately, progress has been made thanks to better education and the availability of more low-cost investment options. Underperformance over the past 5 years fell to 2.7 percent per year, still substantial but much improved. Last year, however, was a throwback to the bad old days as the average investor left nearly 7 percent on the table.

Bond fund investors have fared even more poorly, reaping just 12 cents in profit for every dollar of return provided by the bond market on average over the past 20 years. Ouch.

Research into investor behavior has highlighted the extent to which instinctive responses to perceived physical threats also hinder our ability to rationally evaluate investment choices. Once upon a time, our brains were called upon to instantly assess and react to anything big and scary that wanted to eat us. Essential for survival in the primordial jungle, but not so great for investing.

For example, threat assessment in the human brain instinctively errs on the side of caution: better safe than sorry and always on alert. Unfortunately for the value of our 401(k)s, this innate survival mechanism manifests itself in a behavior called loss aversion. Human investors tend on average to suffer twice the pain from a losing investment as the pleasure derived from a winner, causing them to hold onto bad investments too long and reinforcing poor performance.

Another fascinating and profit-limiting behavior is overconfidence. Psychological studies consistently demonstrate that humans overestimate their abilities relative to the rest of the population. Just like residents of Lake Woebegone, where all of the children are above average, investors routinely rate themselves in the upper echelon. This often leads to excessively frequent trading and virtually assures inferior results.

Researchers in the field of behavioral finance have identified dozens of primal traits that must be resisted in order to invest successfully. This is especially critical in the new world of self-direction and chronic under-funding of retirement savings. The best approach is still the traditional one: get some good advice, create a long term plan, and stick to it no matter what predator is lurking.

Christopher A. Hopkins, a chartered financial analyst, is vice president of Barnett & Co. Investment Advisors.

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